1. 2012 by McGraw-Hill All Rights Reserved 11-1 Lecture slides to accompany Engineering Economy 7th edition Leland Blank Anthony Tarquin Chapter 11Chapter 11 ReplacementReplacement & Retention& Retention

2. 11-2 LEARNINGLEARNING OUTCOMESOUTCOMES 1. Explain replacement terminology and basics 2. Determine economic service life (ESL) 3. Perform replacement/retention study 4. Understand special situations in replacement 5. Perform replacement study over specified time 6. Calculate trade-in value of defender 2012 by McGraw-Hill All Rights Reserved 3. 11-3 Replacement Study BasicsReplacement Study Basics 1. Reduced performance 2. Altered requirements 3. Obsolescence Terminology Defender Currently installed asset Challenger Potential replacement for defender Market value (MV) Value of defender if sold in open market Economic service life No. of years at which lowest AW of cost occurs Defender first cost MV of defender; used as its first cost (P) in analysis Challenger first cost Capital to recover for challenger (usually its P value) Sunk cost Prior expenditure not recoverable from challenger cost Nonowners viewpoint Outsiders (consultants) viewpoint for objectivity Reasons for replacement study 2012 by McGraw-Hill All Rights Reserved 4. 11-4 Example: Replacement BasicsExample: Replacement Basics An asset purchased 2 years ago for $40,000 is harder to maintain than expected. It can be sold now for $12,000 or kept for a maximum of 2 more years, in which case its operating cost will be $20,000 each year, with a salvage value of $9,000 two years from now. A suitable challenger will have a first cost of $60,000 with an annual operating cost of $4,100 per year and a salvage value of $15,000 after 5 years. Determine the values of P, A, n, and S for the defender and challenger for an AW analysis. Solution: Defender: P = $-12,000; A = $-20,000; n = 2; S = $9,000 Challenger: P = $-60,000; A = $-4,100; n = 5; S = $15,000 2012 by McGraw-Hill All Rights Reserved 5. Overview of a Replacement StudyOverview of a Replacement Study Replacement studies are applications of the AW method Study periods (planning horizons) are either specified or unlimited Assumptions for unlimited study period: 1. Services provided for indefinite future 2. Challenger is best available now and for future, and will be repeated in future life cycles 3. Cost estimates for each life cycle for defender and challenger remain the same If study period is specified, assumptions do not hold Replacement study procedures differ for the two cases 2012 by McGraw-Hill All Rights Reserved 11-5 6. 11-6 Economic Service LifeEconomic Service Life Economic service life (ESL) refers to the asset retention time (n) that yields its lowest equivalent AW Determined by calculating AW for 1, 2, 3,n years General equation is: Total AW = capital recovery AW of annual operating costs = CR AW of AOC 2012 by McGraw-Hill All Rights Reserved 7. 11-7 Example: Economic Service LifeExample: Economic Service Life Determine the ESL of an asset which has the costs shown below. Let i = 10% Year Cost,$/year Salvage value,$ 0 - 20,000 - 1 -5,000 10,000 2 -6,500 8,000 3 - 9,000 5,000 4 -11,000 5,000 5 -15,000 3,000 AW1 = - 20,000(A/P,10%,1) 5000(P/F,10%,1)(A/P,10%,1) + 10,000(A/F,10%,1) = $ -17,000 AW2 = - 20,000(A/P,10%,2) [5000(P/F,10%,1) + 6500(P/F,10%,2)](A/P,10%,2) + 8000(A/F,10%,2) = $ -13,429 Similarly, AW3 = $ -13,239 AW4 = $ -12,864 AW5 = $ -13,623 Economic service life is 4 years Solution: 2012 by McGraw-Hill All Rights Reserved 8. 11-8 Performing a Replacement StudyPerforming a Replacement Study 2012 by McGraw-Hill All Rights Reserved 9. 11-9 Performing a Replacement Study --Performing a Replacement Study -- Unlimited Study PeriodUnlimited Study Period 1. Calculate AWD and AWC based on their ESL; select lower AW 2. If AWC was selected in step (1), keep for nC years (i.e., economic service life of challenger); if AWD was selected, keep defender one more year and then repeat analysis (i.e., one- year-later analysis) 3. As long as all estimates remain current in succeeding years, keep defender until nD is reached, and then replace defender with best challenger 4. If any estimates change before nD is reached, repeat steps (1) through (4) Note: If study period is specified, perform steps (1) through (4) only through end of study period (discussed later) 2012 by McGraw-Hill All Rights Reserved 10. 11-10 Example: Replacement AnalysisExample: Replacement Analysis An asset purchased 2 years ago for $40,000 is harder to maintain than expected. It can be sold now for $12,000 or kept for a maximum of 2 more years, in which case its operating cost will be $20,000 each year, with a salvage value of $10,000 after 1 year or $9000 after two years. A suitable challenger will have an annual worth of $-24,000 per year. At an interest rate of 10% per year, should the defender be replaced now, one year from now, or two years from now? Solution: First, determine ESL for defender AWD1 = -12,000(A/P,10%,1) 20,000 + 10,000(A/F,10%,1) = $-23,200 AWD2 = -12,000(A/P,10%,2) 20,000 + 9,000(A/F,10%,2) = $-22,629 ESL is n = 2 years; AWD = $-22,629 Lower AW = $-22,629 Replace defender in 2 years AWC = $-24,000 Note: conduct one-year-later analysis next year 2012 by McGraw-Hill All Rights Reserved 11. 11-11 Additional ConsiderationsAdditional Considerations Opportunity cost approach is the procedure that was previously presented for obtaining P for the defender. The opportunity cost is the money foregone by keeping the defender (i.e., not selling it). This approach is always correct Cash flow approach subtracts income received from sale of defender from first cost of challenger. Potential problems with cash flow approach: Provides falsely low value for capital recovery of challenger Cant be used if remaining life of defender is not same as that of challenger 2012 by McGraw-Hill All Rights Reserved 12. 11-12 Replacement Analysis Over Specified Study PeriodReplacement Analysis Over Specified Study Period Same procedure as before, except calculate AW values over study period instead of over ESL years of nD and nC It is necessary to develop all viable defender-challenger combinations and calculate AW or PW for each one over study period Select option with lowest cost or highest income 2012 by McGraw-Hill All Rights Reserved 13. 11-13 Example: Replacement Analysis; Specified PeriodExample: Replacement Analysis; Specified Period An asset purchased 2 years ago for $40,000 is harder to maintain than expected. It can be sold now for $12,000 or kept for a maximum of 2 more years, in which case its operating cost will be $20,000 each year, with a salvage value of $10,000 after 1 year or $9000 after two. A suitable challenger will have an annual worth of $- 24,000 per year. At an interest rate of 10% per year and over a study period of exactly 2 years, determine when the defender should be replaced. Solution: From previous analysis, AWD for 1 and 2 years, and AWC are: AWD2 = $-22,629 AWC = $-24,000 2012 by McGraw-Hill All Rights Reserved AWD1 = $-23,200 Option Year 1, $ Year 2, $ Year 3, $ AW, $ 1 (C, C, C) -24,000 -24,000 -24,000 -24,000 2 (D, C, C) -23,200 -24,000 -24,000 -23,708 3 (D, D, C) -22,629 -22,629 -24,000 -23,042 Decision: Option 3; Keep D for 2 years, then replace 14. 11-14 Replacement ValueReplacement Value Replacement value (RV) is market/trade-in value of defender that renders AWD and AWC equal to each other If defender can be sold for amount > RV, challenger is the better option, because it will have a lower AW value Set up equation AWD = AWC except use RV in place of P for the defender; then solve for RV 2012 by McGraw-Hill All Rights Reserved 15. 11-15 Example: Replacement ValueExample: Replacement Value An asset purchased 2 years ago for $40,000 is harder to maintain than expected. It can be sold now for $12,000 or kept for a maximum of 2 more years, in which case its operating cost will be $20,000 each year, with a salvage value of $10,000 at the end of year two. A suitable challenger will have an initial cost of $65,000, an annual cost of $15,000, and a salvage value of $18,000 after its 5 year life. Determine the RV of the defender that will render its AW equal to that of the challenger, using an interest rate of 10% per year. Recommend a course of action. - RV(A/P,10%,2) - 20,000 + 10,000(A/F,10%,2) = - 65,000(A/P,10%,5) -15,000 +18,000(A/F,10%,5) RV = $24,228 Solution: Set AWD = AWC Thus, if market value of defender > $24,228, select challenger 2012 by McGraw-Hill All Rights Reserved 16. 11-16 In replacement study, P for presently-owned asset is its market value Summary of Important PointsSummary of Important Points Economic service life is the n value that yields lowest AW In replacement study, if no study period is specified, calculate AW over the respective life of each alternative When study period is specified, must consider all viable defender-challenger combinations in analysis Replacement value (RV) is P value for defender that renders its AW equal to that of challenger 2012 by McGraw-Hill All Rights Reserved Opportunity cost approach is correct, it recognizes money foregone by keeping the defender, not by reducing challengers first cost